Download ECN 111 PRINCIPLES OF MACROECONOMICS SOLUTIONS TO

ECN 111
PRINCIPLES OF MACROECONOMICS
SOLUTIONS TO CHAPTER 15 PRACTICE PROBLEMS
1. One possible intermediate target is the M1 or M2 nominal money supply. Another target is
the nominal interest rate (i). A monetary policy target is an economic variable that the central
bank can affect directly. The Federal Reserve uses monetary targets because it cannot directly
manipulate or influence its monetary policy goals such as high employment, economic growth,
and price stability. The Fed can affect the targets directly; they, in turn, affect variables such as
real GDP and the price level, which are closely related to the Fed’s policy goals. For the last
several decades, the Federal Reserve has been using the short-term nominal federal funds interest
rate as its intermediate target variable.
2. The federal funds interest rate is the nominal interest rate a bank charges another bank for
overnight loans. It is a market clearing interest rate that is determined by the supply and demand
for banks’ excess reserves.
The discount window interest rate is the nominal interest rate that the Federal Reserve charges
banks for loans from the Fed. It is NOT a market-determined interest rate; it is chosen directly
by the Federal Reserve.
3. The Fed tries to achieve a target level for the federal funds rate by using open-market
operations. If it wants to lower the federal funds rate, it will buy treasury bills by performing an
open-market purchase. This purchase will inject the banking system with reserves. The
increased supply of reserves will lower the overnight loan rate on these reserves, which is called
the federal funds rate. Changes in the federal funds rate will usually result in changes in the
interest rates on other short-term financial assets such as treasury bonds, and eventually will
affect longer-term rates such as the rate on corporate bonds and mortgages. However, the effect
on these longer-term rates is usually smaller than the impact on short-term rates and occurs with
a lag.
4. The initial long-run general equilibrium is point A. An increase in open-market purchases of
treasury securities by the Fed will lead to an increase in the M1 nominal supply of money. In the
money market, the ↑ MS leads to a lower nominal interest rate (i). As i ↓, this leads to a ↑ C and
1
↑ I. This increases aggregate demand in the economy, shifting AD up and to the right. As AD
shifts right, producers observe falling inventories, which causes them to increase output as well
as prices. The economy reaches a short-run equilibrium at point B, with higher output (Y2) and
higher prices (P2).
Since actual output is now higher than potential GDP (Y2 > Y*), the labor market is experiencing
a shortage of labor. This drives up the wage rate, which in turn causes firms to increase their
product prices. As firms adjust prices upward, this causes the SRAS to shift up and to the left.
Prices continue to rise until the labor market returns to equilibrium and output returns to
potential GDP (at point C). The price level rises to P3.
5. The initial long-run general equilibrium is point A. A shortage of food drives up food prices,
which causes firms to raise their product prices and shifts SRAS up and to the left. (This is the
“adverse”—or negative—part of the supply shock.) As prices rise, we move along the aggregate
demand curve. There is a decrease in the quantity of AD demanded due to the Pigou wealth
effect (↓ C) and the Keynes interest-rate effect (↓ I). This results in unexpected increases in
inventories, so firms reduce their output. The economy reaches a short-run equilibrium at point
B, with higher prices (P2) and lower output (Y2).
This economy is now experiencing a recession (since Y2 is less than potential GDP). The labor
market has a surplus of workers, which would ultimately lead to lower wages if you let the
market adjust naturally. However, as a Fed policymaker, you are anxious for the economy to
return to full-employment and potential GDP as fast as possible. You don’t want to wait for the
normal market adjustment process. (You are more Keynesian than classical!)
To stimulate spending then, the Fed can increase the M1 nominal money supply, which would
shift the AD curve up and to the right. Why? Because in the money market, the ↑ MS leads to a
lower nominal interest rate (i). As i ↓, this leads to a ↑ C and ↑ I. Now, as aggregate demand
2
increases, firms observe their inventories fall, and start to increase production once again.
Production continues to rise until the inventories return to their planned levels and the labor
market returns to full-employment. At the new long-run general equilibrium, point C, the
general price level is higher (P3 > P2) and actual output equals potential GDP (Y*).
3